Is the U.S. dollar headed for a breakdown?

Opinion: The yen holds the key for the U.S. dollar going forward

By

AnthonyMirhaydari

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Late last month, I warned that it wasn’t earnings or economics that was really driving the market. It was currencies. Specifically, the yen-carry trade — the two-sided trade that hedge funds and other traders have been using to raise funds to buy stocks (shorting the yen then going long dollars, euros, and risky assets). But will that still work?

As long as the Japanese yen weakened against the U.S. dollar and the euro, the market would keep climbing. But if the opposite happened, this complacent, vulnerable market would unravel fast enough to make your head spin.

That’s what happened last October, amid the rancor over the debt limit and the government shutdown, when the dollar slumped to test the bottom of a trading range going back to 2011. Stocks suffered, as expected, before the bulls pulled it together. The dollar strengthened. The yen weakened. All was right in the world again.

Yet the threat against the greenback builds anew: On May 8, the dollar, on an intraday basis, dropped below its October low and threatened a technical breakdown that could have put the 2011 lows — resulting from the loss of America’s AAA credit rating that August — back in play. That risks a near 9% drop for the dollar from current levels, with all that entails, including higher import prices, higher oil prices, higher interest rates and loss of national prestige.

Will a breakdown in the dollar happen? The signs don’t look good.

Here at home, fundamental catalysts are working against the dollar.

Inflation is climbing, with price pressures building in the supply chain on a scale not seen since early 2012. Interest rates are dropping as the bond market worries about the health of the overall economy amid soft data points such as Tuesday’s dismal retail sales report. A contentious mid-term election approaches. And the Federal Reserve continues to try to push back the date of the first short-term interest rates hike well into 2015.

All of these are negatives for a currency’s valuation. But what I’m most worried about, in the near term, is the pressure the yen-carry trade is coming under.

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The Japanese yen is poised for a massive upside breakout from the tight consolidation range that it has held since January as it becomes increasingly clear Tokyo’s currency-devaluation-as-salvation strategy is exactly panning out. A weaker yen was supposed to juice exports and restore economic vitality to the Land of the Rising Sun. Instead, it merely caused higher food and fuel prices, pinched consumer-purchasing power, and encouraged Asian neighbors, including China and South Korea, to actively weaken their currencies in response.

A stronger yen will encourage selling in the dollar and the euro, as well as stocks, as the yen-carry trades are closed.

Moreover, the euro is weakening here as the European Central Bank moves closer to new stimulus action in response to a rising deflation threat in its weak peripheral economies, including Spain. The chatter has been that the normally hawkish German Bundesbank would sign off on new stimulus action if inflation forecasts out to 2016 weakened. Thursday morning, the ECB’s Survey of Professional Forecasters revealed exactly that.

Disturbances in the yen-carry trade explains Thursday’s market wipeout, with the S&P 500 below its 50-day moving average and the Russell 2000 small-cap index in free fall to new correction lows.

What’s really going to make things exciting is when the volatility that’s emerging now, after the easy rise investors were spoiled with in 2013, hits the dollar. As a drop in the U.S. Dollar Index below 79, as shown in the chart above, will cue the fireworks are starting.

In response, I’m recommending investors maintain a defensive posture with a focus on positions like the Direxion 3x Treasury Bond Bull
TMF, -0.90%
, which I just closed for a 22% profit in my Edge Letter Sample Portfolio. My latest addition is the VelocityShares 2x VIX
TVIX, +2.01%
a leveraged play on the CBOE Volatility Index, or “fear gauge,” that rises when stocks are falling.

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